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The mixed attribute model in SFAS 133 cash flow hedge accounting: implications for market pricing

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Abstract

In this study, we examine the pricing of cash flow hedge adjustments reported in other comprehensive income (OCICF), under the mixed attribute model in SFAS 133 Accounting for Derivative Instruments and Hedging Activities. Our OCICF pricing investigation integrates empirical research on the derivatives use that gives rise to such mark-to-market adjustments with the accounting information pricing literature. Based on this integration, we generalize mispricing theory for the SFAS 133 mixed attribute model and predict both the direction and magnitude of OCICF pricing. Screening on U.S. multinationals with ex ante exposure to currency risk, we provide evidence of OCICF mispricing in the expected direction, consistent with the notion that SFAS 133 cash flow hedge accounting results in a mixed attribute problem (Gigler et al. in J Account Res 45:257–287, 2007). Moreover, we find that both OCICF gains and losses are inversely related to future cash flows and of the expected magnitude, consistent with our predictions based on valuation theory (for example, Ohlson in Rev Account Stud 4:145–162, 1999). Our results support the Financial Accounting Standards Board’s concern that the SFAS 133 mixed attribute model does not provide the information necessary for investors to understand the net economic effects of derivatives use (FASB in Accounting for financial instruments and revisions to the accounting for derivative instruments and hedging activities. FASB, Norwalk, 2010).

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Notes

  1. In accounting for cash flow hedges under SFAS 133 a MAP arises when the derivative position is marked to market while the adjustments on the underlying hedged item is not recorded until the future transaction. This absence of information on the future transaction being hedged, along with the complexities inherent in cash flow hedge accounting, may give rise to OCICF mispricing. As Gigler et al. (2007) observe, cash flow hedges are “an extreme example of this mixed attribute problem … [and thus] it is unclear how outsiders would interpret any reported gains or losses on the derivative” (p. 259). More generally, the mixed attribute model allows some assets and liabilities to be recorded at cost, lower of cost or market, and fair value. The Federal Advisory Committee on Improvements to Financial Reporting has expressed concern about the substantive complexities inherent in this model (Committee on Improvements to Financial Reporting 2008). As discussed in Sect. 2, Exhibit 1 illustrates the mixed attribute model as well as the additional complexities inherent in the accounting for partial hedging.

  2. As discussed in Sect. 2, the FXDs cash flow hedge net economic effect is systematic and varies with the firm’s hedge percentage. Specifically, this effect relative to OCICF equals 1 − (1/hedge percentage), assuming no ineffective hedging of a given exchange rate change and no premium paid or received on the derivative contract.

  3. Indicative of the incomplete information on cash flow hedges under SFAS 133, Campbell (2010) provides evidence of delayed OCICF pricing for a sample of financial and nonfinancial firms. Unlike Campbell, we predict the direction of such mispricing for a sample of financial firms based on the integration of empirical and theoretical research on the use of FXDs and MAP mispricing under SFAS 133. Moreover, we generalize MAP mispricing theory, and predict both the direction and magnitude of OCICF pricing.

  4. Additional mandatory disclosure that includes the extent of hedging may help mitigate the mixed attribute problem, but as Hughes et al. (2002) suggest, such disclosure also may reveal proprietary information to rival firms. During the recent financial crisis, and accompanying pressure from Congress, the FASB modified its mark-to-market guidelines for inactive markets and distressed transactions (FASB 2009). In its recent exposure draft, the FASB has proposed that cash flow hedges need not be highly effective to qualify for hedge accounting (FASB 2010). Rather, qualifying cash flow hedges only need be reasonably effective. This reasonably effective criterion could allow firms some flexibility in recognizing some hedging relationships as ineffective and thereby avoid the mixed attribute problem. However, we believe that the mixed attribute problem in cash flow hedge accounting is likely to persist. The International Accounting Standards Board (IASB) also recently issued an exposure draft entitled Hedge Accounting (IASB 2010), which concerns International Accounting Standard 39 (IAS 39) Financial Instruments: Recognition and Measurement (IASB 2004). In its 2010 exposure draft, the IASB intends to improve the alignment between hedge accounting and firms’ risk management activities. In response to this IASB exposure draft, the FASB issued a discussion paper entitled Selected Issues about Hedge Accounting (FASB 2011).

  5. Indeed, a cornerstone of SFAS 133 is that “fair value is the most relevant measure for financial instruments and the only relevant measure for derivative instruments” (paragraph 3).

  6. See Gastineau et al. (2001) for additional discussion of the complexities in derivatives use and SFAS 133 hedge accounting.

  7. The MAP pricing implications summarized in Exhibit 1 assume a constant exchange rate after time t, for clarity. These implications are not affected by this assumption, because the MTM adjustment on the hedge (i.e., OCICF) is always less than the MTM on the hedged item (e.g., INV) in a partial hedge. For additional discussion, refer to Sect. 2.2, including “Appendix”.

  8. Brav and Heaton (2002) provide a review of the empirical research that supports Merton’s (1987) theoretical model.

  9. Consistent with our expectations, Campbell (2010) reports an inverse relationship between OCICF adjustments and future returns. He interprets such delayed pricing as evidence of a lack of transparency in SFAS 133 cash flow hedge accounting. Beyond Campbell, we also predict that the magnitude of this inverse relationship will be less than minus one.

  10. The MAP pricing implications summarized in Exhibit 1 pertain to partial hedges, which are prevalent in FXDs use (e.g., Bodnar et al. 1998). In contrast, when a firm effectively hedges 100 % of its underlying exposure (i.e., a full hedge), the first implication no longer holds (i.e., |OCICFt| = |∆INVt+1| in full hedges). The second implication, however, continues to hold (i.e., ∆INVt+1 = −f (OCICFt) in full hedges).

  11. This systematic relationship assumes no ineffective hedging of a given exchange rate change and no premium paid or received on the derivatives contract.

  12. Exhibit 1 illustrates a 40 % partial hedge (i.e., US$60,000 FXDs hedge of US$150,000 hedged inventory item). As summarized in the exhibit’s last row, the net economic effect of this 40 % hedge is 1.5 times the magnitude of the OCICF adjustment. In particular, firm A (firm B) records a US$6 OCICF gain (US$3 OCICF loss) and experiences a US$9 net cash outflow (US$4.50 net cash inflow). Thus, the net future cash flow of a 40 % partial hedge equals −1.5 times the OCICF value.

  13. Similarly, Marshall and Weetman (2007) document a lack of transparency by comparing survey evidence of currency risk management practices to disclosures of such practices. Li et al. (2009) report that the mark-to-market adjustments on energy contracts are not value relevant.

  14. As introduced in Sect. 1 and illustrated in Exhibit 1, the mixed attribute problem is inherent in OCICF adjustments, where the derivative position is marked to market, but the adjustment on the underlying hedged item is not recorded until the future transaction.

  15. In addition to Louis (2003), Pinto (2005) concludes that OCICFTA is a significant source of value relevant information to investors. Similarly, Bernstein (1993) suggests that increasing OCICFTA over the years may be indicative of poorly managed foreign exchange exposure and thus has information value to investors. Radhahrishnan and Tsang (2006) report that OCICFTA is positively associated with abnormal returns for R&D leaders and asset intensive R&D followers.

  16. As introduced in Sect. 1, both the OCICF and the OCIFCTA variables provide information on currency risk information reported in the other comprehensive income component of equity. However, unlike the SFAS 133 OCICF variable, the OCIFCTA variable pertains to the conversion of foreign currency denominated financial statements that have no direct cash flow implications (e.g., Hagelin and Pramborg 2004). Accordingly, OCIFCTA will not give rise to the derivatives use described by the Gigler et al. (2007) MAP mispricing theory, in an optimal hedge framework (e.g., Stulz 1984; Froot et al. 1993).

  17. Four of the 144 firms in our final sample do not report notional values of FXDs. Our primary results are robust to the exclusion of these firms.

  18. Self-selection bias may not affect our results if firms’ derivatives use is by chance, rather than by design. See Bradshaw and Miller (2008) for a discussion of cases where self selection may not result in sample bias.

  19. This two-stage procedure has been used frequently in accounting research to control for self-selection bias (e.g., Harris and Muller 1999; Leuz and Verrecchia 2000; Alam and Loh 2004; Cheney et al. 2004; Bartov et al. 2005).

  20. In an unrelated paper, Campbell (2010) takes a similar approach but uses raw returns and OCICF deciles in place of our size-adjusted abnormal returns and OCICF quintiles. We also examine the sensitivity of our hedge portfolio tests to abnormal returns obtained from the Fama and French (1996) three factor model and use firm and year clustered standard errors to mitigate concerns of time-series and cross-sectional correlations.

  21. For example, Kraft et al. (2007) include 111,838 firm-year observations in their full sample and 65,411 firm-year observations in their restricted sample.

  22. The control variables that we use in our OLS regression of future abnormal returns are similar to other studies that examine market mispricing issues (e.g., Rajgopal et al. 2003).

  23. As discussed in Sect. 3, not all firms in our initial sample use cash flow hedges. Thus we employ a two-stage procedure to control for self-selection bias (Heckman 1979).

  24. The OCICF mispricing result is robust to excluding the InverseMills variable (which controls for self-selection bias) from the Mishkin tests.

  25. Prior research identifies various sources of mispricing that the capital asset pricing model (CAPM) does not capture. Ball and Brown (1968) identify the phenomena of post-earnings announcement drift, which indicates that the stock price of firms experiencing positive (negative) earnings surprises tends to drift upward (downward). Banz (1981) identifies that small firms earn abnormally high average returns, and Rosenberg et al. (1985) find similar returns for firms with high book-to-market ratios. DeBondt and Thaler (1985) report that firms with low (high) prior long-term returns tend to experience higher (lower) future returns. Jegadeesh and Titman (1993) add the momentum factor to the three-factor Fama and French model (1993), indicating that firms with high (low) prior returns earn high (low) future returns. Lakonishok et al. (1994) demonstrate that investors consistently over-estimate the growth rates of glamour stocks relative to value stocks. Our research method is designed to mitigate concerns about the validity of the CAPM.

  26. Sloan (1996) and various other studies in the accounting literature report that investors earn higher average returns by investing in firms with relatively lower total accruals. Fairfield et al. (2003) demonstrate that firms reporting high investments experience lower stock returns. Basu (1977) provides evidence showing that firms with high earnings-to-price ratios earn positive abnormal returns. Overall, these studies demonstrate that there are various opportunities to earn abnormal returns in the short run. Our study illustrates that abnormal returns also exist in OCICF pricing.

  27. When firms hedge less than 100 % of their underlying exposure, this is referred to as a partial hedge (e.g., Bodnar et al. 1998, p. 77). Partial hedges give rise to underhedging.

  28. Gigler et al. (2007) illustrate their model using a commodity sale as the hedged item, but note that “the real transaction (the hedged item) can also be interpreted as the future purchase of inputs needed for production, or as a foreign currency transaction” (p. 262). Although we use FX transactions in our hypothesis development, the same logic can be applied to other derivatives used as cash flow hedges (e.g., commodity prices, interest rates).

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Acknowledgments

We would like to acknowledge the efforts of Stephen Penman (editor) and an anonymous referee that have helped improve our paper. A previous version of the paper also benefited from participants at the American Accounting Association’s 2009 Annual Meeting.

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Authors and Affiliations

  1. Department of Accounting, College of Business, University of Wisconsin Oshkosh, Oshkosh, WI, USA

    Stephen Makar

  2. School of Accountancy, College of Business Administration, The University of Akron, Akron, OH, USA

    Li Wang

  3. Department of Accounting, College of Business Administration, Kent State University, Kent, OH, USA

    Pervaiz Alam

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  1. Stephen Makar
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Correspondence to Stephen Makar.

Appendix: Hypothesis development

Appendix: Hypothesis development

Our hypothesis development integrates prior research on derivatives use with the accounting information pricing literature and generalizes extant theory on the mispricing of cash flow hedge accounting adjustments. Survey data (for example, Bodnar et al. 1998) indicate that most firms use derivatives to hedge less than 100 % of their foreign currency (FX) exposure.Footnote 27 As modeled by Gigler et al. (2007), the derivatives position for these partial hedging firms is:

$$ {\text{z}} = {\text{q}} + {\text{s }}\left( {{\text{z}} > 0,\quad {\text{q}} > 0,\,{\text{and}}\,{\text{s}} < 0} \right);\quad {\text{therefore}}\,{\text{z}} < {\text{q}}\,{\text{and}}\,\left| {{\text{z}}\theta } \right| < \left| {{\text{q}}\theta } \right|. $$

where

  • q = the magnitude of a future transaction in foreign currency;

  • z = management derivative position (FXDs);

  • s = management speculative position;

  • θ = change in FX rate (increase or decrease).

Under current GAAP, the effect of the rate change on FXDs, |zθ|, is marked-to-market (MTM) in other comprehensive income (OCICF) and observable to investors at time t; however, the effect on the underlying hedged item, |qθ|, is not MTM and not observable to investors in the same period. Because |zθ| < |qθ| and |qθ| is not observable until the hedged item is settled at time t + 1, we expect that observing |zθ| at time t will lead investors to underestimate the implications of |zθ| for future cash flows |qθ|, where |zθ| is always less than |qθ| in a partial hedge. For example, as illustrated in Exhibit 1 at time t:Footnote 28

1.1 Firm A (US$ decline)

zθ (OCICF, observable) = gain of $6,000 (10 % ∆US$/1€ * €60K FXDs);

qθ (unobservable) = loss of $15,000 (10 % ∆US$/1€ * €150K Inventory).

1.2 Firm B (US$ increase)

zθ (OCICF, observable) = loss of $3,000 (5 % ∆US$/1€ * €60 K FXDs);

qθ (unobservable) = gain of $7,500 (5 % ∆US$/1€ * €150 K Inventory).

Because both firms are partial hedgers, |zθ| is less than |qθ|, regardless of the direction of the price change (for example, US$ decline or US$ increase). Because investors observe only zθ at time t and both z and q are not disclosed under the current accounting standards, we expect that, at time t, investors will underestimate the implications of zθ for future cash flows qθ. This leads to our hypothesis (in alternate form):

H a

Investors underestimate the implications of the cash flow hedge adjustments reported in other comprehensive income (OCICF) for future cash flows.

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Makar, S., Wang, L. & Alam, P. The mixed attribute model in SFAS 133 cash flow hedge accounting: implications for market pricing. Rev Account Stud 18, 66–94 (2013). https://doi.org/10.1007/s11142-012-9201-z

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